Of Interest

Wednesday, January 12, 2011

During the holidays, I pondered on Japans economy and found the least bad route was by asking myself a series of questions.

Does Japan really matter?
Yes, for two reasons. Its experience with a massive asset bubble collapse, a paralyzed banking sector and years of deflation suggest how events might play themselves out in the U.S., which seems to be suffering an echo of Japan’s misfortunes. But even if Japan isn’t a template for the U.S., how Japan’s economy plays itself out could be of significance for the global financial system. Japan, after all, remains the second largest developed-world economy, remains the richest large economy on a per capita basis and has a huge financial sector.Can the U.S. escape Japan’s plight?
Fed chairman Ben Bernanke certainly thinks so, and is doing his utmost to ensure the U.S. does. That’s what was behind both rounds of quantitative easing: making sure Japan-style deflation isn’t repeated.Could Japan finally be on the cusp of a “normal” recovery?
The premise behind two decades of routine and extreme monetary and fiscal stimulus has been that Japan suffers from a shortfall in aggregate demand caused by the 1990 stock market and real estate bust. The central Keynesian thesis has always been that once Japan’s banking sector could be cleared up and its excess capacity shrunk, the economy would move back to self-sustaining growth. But Japan has had 15 years of near-zero interest rates and deficit spending that’s taken the government’s net debt from 12% of GDP in 1992 to a forecast 130% this year. Growth looked reasonable during the early parts of the new millennium. But at between 1.9% and 2.7%, it was paltry relative to the pace that prevailed during the 1980s, when Japan was on top of the world and GDP was expanding at an average annual rate of nearly 4.5%. What’s more, even the growth of the last decade continued to be heavily dependent on official stimulus. Could it be that demographics rather than a shortfall in aggregate demand is behind the decline in Japan’s trend growth? But if that’s the case, why isn’t inflation picking up?Is Japan reaching the limits of Keynesian stimulus?
Even at a mere 1.2% yield on 10-year Japanese government bonds, Japan’s enormous official debt load means that interest payments alone soak up more than a quarter of government revenue. The IMF expects Japan to run annual deficits worth 7.5% of GDP for much of the coming decade. At some point investors will start to worry about getting paid. Not that Japan is likely to default, the debt is in its own currency, which the Bank of Japan can print at will. But they might start to get the nagging feeling that the government has no control of its deficits and no ability to cut them back and that the money printing will become straight debt monetization.What is Japan’s endgame?
A massive debt load, an inability to cut deficits, debt monetization; all Japan’s roads lead to inflation. Not a little inflation, but hyperinflation. So says Dylan Gryce, a strategist at Societe Generale, and it’s hard to fault his case. This great Japanese unwind could start to happen sooner rather than later. Ironically, it could be triggered by expectations of global recovery, if this were to cause yields to be squeezed up worldwide. It wouldn’t take much of a yield increase for the Japanese economy to be sucked into a vicious cycle of higher deficits, caused by higher interest costs, forcing ever higher yields. Domestic investors have been content to fund the government’s shortfalls. But the domestic savings rate has been dropping as the country ages. Pretty soon it will go negative and the government will have to look to foreigners for finance. And foreigners won’t be content with 1% yields with the prospects of massive devaluation.Where does that leave the rest of the world?
A number of things could happen if Japan were to succumb to hyperinflation. Investors would undoubtedly flee Japanese fixed-income investments. Would this benefit “high quality” sovereign debt elsewhere? Or would investors decide that all sovereign debt is due a higher risk premium. In which case, alternatives would be preferred? Most probably the sort of stuff that governments can’t make more of. Like commodities. What’s certain is that there would be some serious ructions in global markets.By Alen Mattich.WSJ.